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Models: An Introduction

Dynamic stochastic general equilibrium

models are playing an important role in the

formulation and communication of monetary

policy at many of the worlds central banks.

dependence of current choices on expected

future outcomes, have moved from academic

circles to the policymaking communitybut

they are not well known to the general public.

DSGE framework by using a small-scale

model to show how to address specific

monetary policy questions; the authors

focus on the causes of the sudden pickup

in inflation in the first half of 2004.

is that the management of expectations can

be a more effective tool for stabilizing inflation

than actual movements in the policy rate;

this result is consistent with the increasing

focus on central bankers pronouncements

of their future actions.

senior economist at the Federal Reserve Bank of New York; Krishna Rao is

a graduate student at Stanford University; Kieran Walsh is a graduate student

at Yale University.

Correspondence: argia.sbordone@ny.frb.org, andrea.tambalotti@ny.frb.org

1. Introduction

the formulation and communication of monetary policy

at a number of central banks around the world. Many of

these banks now present their economic outlook and policy

strategies to the public in a more formal way, a process

accompanied by the introduction of modern analytical tools

and advanced econometric methods in forecasting and policy

simulations. Official publications by central banks that

formally adopt a monetary policy strategy of inflation

targetingsuch as the Inflation Report issued by the Bank

of England and the monetary policy reports issued by the

Riksbank and Norges Bankhave progressively introduced

into the policy process the language and methodologies

developed in the modern dynamic macroeconomic literature.1

The development of medium-scale DSGE (dynamic

stochastic general equilibrium) models has played a key role

in this process.2 These models are built on microeconomic

foundations and emphasize agents intertemporal choice.

The dependence of current choices on future uncertain

1

The Bank of England has published a quarterly Inflation Report since 1993.

The report sets out the detailed economic analysis and inflation projections on

which the Banks Monetary Policy Committee bases its interest rate decisions.

The Riksbank and Norges Bank each publish monetary policy reports three

times a year. These reports contain forecasts for the economy and an

assessment of the interest rate outlook for the medium term.

2

A simple exposition of this class of models can be found in Gal and Gertler

(2007). Woodford (2003) provides an exhaustive textbook treatment.

The authors thank Ariel Zetlin-Jones for his contribution to the early stages

of this work. The views expressed are those of the authors and do not

necessarily reflect the position of the Federal Reserve Bank of New York

or the Federal Reserve System.

23

role to agents expectations in the determination of current

macroeconomic outcomes. In addition, the models general

equilibrium nature captures the interaction between policy

actions and agents behavior. Furthermore, a more detailed

specification of the stochastic shocks that give rise to economic

fluctuations allows one to trace more clearly the shocks

transmission to the economy.

The use of DSGE models as a potential tool for policy

analysis has contributed to their diffusion from academic to

policymaking circles. However, the models remain less wellknown to the general public. To broaden the understanding of

these models, this article offers a simple illustration of how an

estimated model in this class can be used to answer specific

monetary policy questions. To that end, we introduce the

structure of DSGE models by presenting a simple model,

meant to flesh out their distinctive features. Before proceeding

to a formal description of the optimization problems solved by

firms and consumers, we use a simple diagram to illustrate

the interactions among the main agents in the economy. With

the theoretical structure in place, we discuss the features of the

estimated model and the extent to which it approximates the

volatility and comovement of economic time series. We also

discuss important outcomes of the estimationnamely, the

how an estimated [DSGE] model . . . can

be used to answer specific monetary

policy questions.

possibility of recovering the structural shocks that drive

economic fluctuations as well as the historical behavior of

variables that are relevant for policy but are not directly

observable. We conclude by applying the DSGE tool to study

the role of monetary policy in a recent episode of an increase in

inflation. The lesson we emphasize is that, while they are a very

stylized representation of the real economy, DSGE models

provide a disciplined way of thinking about the economic

outlook and its interaction with policy.3

We work with a small model in order to make the

transmission mechanism of monetary policy, whose basic

contours our model shares with most DSGE specifications,

as transparent as possible. Therefore, the model focuses on

the behavior of only three major macroeconomic variables:

inflation, GDP growth, and the short-term interest rate.

3

Adolfson et al. (2007) offer a more extended illustration of how DSGE models

can be used to address questions that policymakers confront in practice. Erceg,

Guerrieri, and Gust (2006) illustrate policy simulations with an open-economy

DSGE model.

24

be enriched to provide more details on the structure of the

economy. In fact, a key advantage of DSGE models is that they

share core assumptions on the behavior of households and

firms, which makes them easily scalable to include details that

are relevant to address the question at hand. Indeed, several

they share core assumptions on the

behavior of households and firms, which

makes them easily scalable to include

details that are relevant to address the

question at hand.

extensions of the basic framework presented here have been

developed in the literature, including the introduction of wage

stickiness and frictions in the capital accumulation process

(see the popular model of Smets and Wouters [2007]) and a

treatment of wage bargaining and labor market search (Gertler,

Sala, and Trigari 2008).4 Recently, the 2008 financial crisis has

highlighted one key area where DSGE models must develop:

the inclusion of a more sophisticated financial intermediation

sector. There is a large body of work under way to model

financial frictions within the baseline DSGE frameworkwork

that is very promising for the study of financial intermediation

as a source and conduit of shocks as well as for its implications

for monetary policy. However, this last generation of models

has not yet been subjected to extensive empirical analysis.

Our study is organized as follows. Section 2 describes the

general structure of our model while Section 3 illustrates its

construction from microeconomic foundations. Section 4

briefly describes our approach to estimation and presents some

of the models empirical properties. In Section 5, we use the

model to analyze the inflationary episode of the first half of

2004. Section 6 concludes.

Basic Structure

Dynamic stochastic general equilibrium models used for policy

analysis share a fairly simple structure, built around three

interrelated blocks: a demand block, a supply block, and a

4

Some of these larger DSGE models inform policy analysis at central banks

around the world: Smets and Wouters (2007) of the European Central Bank;

Edge, Kiley, and Laforte (2008) of the Federal Reserve System; and Adolfson

et al. (2008) of the Riksbank.

Mark-up

shocks

Demand

shocks

Y = f YY(Y e, i - ee,...)

Demand

Productivity

shocks

= f ( e,Y,...)

Supply

Y e, e

Expectations

i = f i( *,Y,...)

Monetary policy

Policy

shocks

these blocks derive from microfoundations: explicit

assumptions about the behavior of the main economic actors

in the economyhouseholds, firms, and the government.

These agents interact in markets that clear every period, which

leads to the general equilibrium feature of the models.

Section 3 presents the microfoundations of a simple DSGE

model and derives the equations that define its equilibrium.

But first, we begin by introducing the basic components

common to most DSGE models with the aid of a diagram.

In the diagram, the three interrelated blocks are depicted as

rectangles. The demand block determines real activity Y as

a function of the ex ante real interest ratethe nominal rate

e

minus expected inflation i and of expectations about

e

future real activity Y . This block captures the idea that, when

real interest rates are temporarily high, people and firms would

rather save than consume or invest. At the same time, people

are willing to spend more when future prospects are promising

e

( Y is high), regardless of the level of interest rates.

The line connecting the demand block to the supply block

shows that the level of activity Y emerging from the demand

block is a key input in the determination of inflation ,

e

together with expectations of future inflation . In

prosperous times, when the level of activity is high, firms must

increase wages to induce employees to work longer hours.

Higher wages increase marginal costs, putting pressure on

prices and generating inflation. Moreover, the higher inflation

is expected to be in the future, the higher is this increase in

prices, thus contributing to a rise in inflation today.

The determination of output and inflation from the

demand and supply blocks feeds into the monetary policy

block, as indicated by the dashed lines. The equation in that

block describes how the central bank sets the nominal interest

reflects the tendency of central banks to raise the short-term

interest rate when the economy is overheating as well as when

inflation rises and to lower it in the presence of economic slack.

By adjusting the nominal interest rate, monetary policy in turn

affects real activity and through it inflation, as represented by

the line flowing from the monetary policy block to the demand

block and then to the supply block. The policy rule therefore

closes the circle, giving us a complete model of the relationship

between three key endogenous variables: output Y , inflation

, and the nominal interest rate i .

While this brief description appears static, one of the

fundamental features of DSGE models is the dynamic

interaction between the blockshence, the dynamic aspect

of the DSGE labelin the sense that expectations about the

future are a crucial determinant of todays outcomes. These

expectations are pinned down by the same mechanism that

generates outcomes today. Therefore, output and inflation

DSGE models is the dynamic interaction

between the [three interrelated] blocks

hence, the dynamic aspect of the DSGE

labelin the sense that expectations

about the future are a crucial determinant

of todays outcomes.

tomorrow, and thus their expectations as of today, depend on

monetary policy tomorrow in the same way as they do today

of course, taking into account what will happen from then

on into the infinite future.

The diagram highlights the role of expectations and the

dynamic connections between the blocks that they create.

The influence of expectations on the economy is represented by

the arrows, which flow from monetary policy to the demand

and then the supply block, where output and inflation are

determined. This is to emphasize that the conduct of monetary

policy has a large influence on the formation of expectations.

In fact, in DSGE models, expectations are the main channel

through which policy affects the economy, a feature that is

consistent with the close attention paid by financial markets

and the public to the pronouncements of central banks on their

likely course of action.

The last component of DSGE models captured in the

diagram is their stochastic nature. Every period, random

exogenous events perturb the equilibrium conditions in each

block, injecting uncertainty in the evolution of the economy

25

shocks, the economy would evolve along a perfectly predictable

path, with neither booms nor recessions. We represent these

shocks as triangles, with arrows pointing toward the

equilibrium conditions on which they directly impinge. Markup and productivity shocks, for example, affect the pricing and

production decisions of firms that underlie the supply block,

while demand shocks capture changes in the willingness of

households to purchase the goods produced by those firms.

3. Microfoundations of a Simple

DSGE Model

We present the microfoundations of a small DSGE model that

is simple enough to fit closely into the stylized structure

outlined in our diagram. Our objective is to describe the basic

components of DSGE models from a more formal perspective,

using the mathematical language of economists, but avoiding

unnecessary technical details. Despite its simplicity, our model

is rich enough to provide a satisfactory empirical account of the

evolution of output, inflation, and the nominal interest rate in

the United States in the last twenty years, as we discuss in the

next section.

Given the constraints we impose on this treatment for the

sake of simplicity, our model lacks many features that are

standard in the DSGE models that central banks typically use.

For example, we ignore the process of capital accumulation,

enough to provide a satisfactory empirical

account of the evolution of output,

inflation, and the nominal interest rate in

the United States in the last twenty years.

by firmsto the economys demand block. Nor do we attempt

to model the labor market in detail: for example, we make no

distinction between the number of hours worked by each

employee and the number of people at work, an issue that is

hard to overlook in a period with unemployment close to

10 percent. Finally, we exclude any impediment to the smooth

functioning of financial markets and assume that the central

bank can perfectly control the short-term interest ratethe

only relevant rate of return in the economy. The 2008 financial

crisis has proved that this set of assumptions can fail miserably

26

more nuanced view of financial markets within the current

generation of DSGE models, as we observe in our introduction.

Our model economy is populated by four classes of agents:

a representative household, a representative final-goodproducing firm (f-firm), a continuum of intermediate firms

(i-firms) indexed by i 0 1, and a monetary authority. The

household consumes the final good and works for the i-firms.

Each of these firms is a monopolist in the production of a

particular intermediate good i , for which it is thus able to

four classes of agents: a representative

household, a representative final-goodproducing firm, . . . a continuum of

intermediate firms, . . . and a monetary

authority.

produced by the i-firms and sells the product to households in

a competitive market. The monetary authority sets the nominal

interest rate.

The remainder of this section describes the problem faced

by each economic agent, shows the corresponding optimization conditions, and interprets the shocks that perturb these

conditions. These optimization conditions result in dynamic

relationships among macroeconomic variables that define the

three model blocks described above. Together with market

clearing conditions, these relationships completely characterize

the equilibrium behavior of the model economy.

Demand Block

At the core of the demand side of virtually all DSGE models

is a negative relationship between the real interest rate and

desired spending. In our simple model, the only source of

spending is consumption. Therefore, the negative relationship

between the interest rate and demand emerges from the

consumption decision of households.

choice of a very large representative householdthe entire

U.S. populationwhich maximizes its expected discounted

lifetime utility, looking forward from an arbitrary date t 0

s

Et

bt + s log Ct + s

Max

0

0

0

s = 0 s = 0

Bt + s Ct + s Ht + s i

the Lagrangian

s

bt 0 + s log Ct + s Ct + s 1

L = Et

0

0

0

s=0

Ct

i 0 1

1

0+s1

v Ht

0+s

B

Pt C t + -----t B t 1 +

Rt

i di

Bt

0+s

Pt

0+s1

0+s

Ct

0 Wt

0+s

0+s

i di

+ Bt

0 +s

0+s

Rt

i Ht + s i di

0 +s

0

0 wt i Ht i di ,

0

household, we call them Americans, like consumption, Ct ,

but dislike the number of hours they spend at work, Ht , to

an extent described by the convex function . The utility

flow from consumption depends on current as well as past

consumption, with a coefficient . As a result of this habit,

consumers are unhappy if their current consumption is low,

but also if it falls much below the level of their consumption in

the recent past. To afford consumption, Americans work a

certain amount of hours Ht i in each of the i-firms, where they

earn an hourly nominal wage Wt i which they take as given

when deciding how much to work.5 With the income thus

earned, they can purchase the final good at price Pt or save by

accumulating one-period discount government bonds Bt ,

whose gross rate of return between t and t + 1 is Rt .

From the perspective of time t , the household discounts

utility in period t + 1 by a time-varying factor bt + 1 bt , where

bt + 1 bt is an exogenous stochastic process. Changes in bt + 1 bt

represent shocks to the households impatience. When bt + 1

increases relative to bt , for example, the household cares more

about the future and thus wishes to save more and consume

less today, everything else equal. In this respect, bt + 1 bt acts as

a traditional demand shock, which affects desired consumption

and saving exogenously. A persistent increase in bt + 1 bt is one

way of interpreting the current macroeconomic situation in the

United States, in which households have curtailed their

consumptionpartly to build their savings. Of course, in

reality there are many complex reasons behind this observed

change in behavior, and an increase in peoples concern about

the future is surely one of them. For simplicity, the model

focuses on this one reason exclusively.

5

v Ht

at the level at which the supply of labor by the household equals the demand of

labor by firms. This labor demand in turn is determined by the need of firms

to hire enough workers to satisfy the demand for their products, as we describe

in the next section.

(3.1a)

(3.1b)

L------: t = Et t + 1 R t

Bt

bt + 1 bt

L

1

-------- : -----t P = -------------------------- .

Et -------------------------C

Ct bt t

Ct Ct 1

t + 1 Ct

for t = t 0 t 0 + 1 , and

(3.2)

Ht i

L

--------------- : --------------------- = Wt i

Ht i

t bt

sequence of budget constraints.

These conditions yield a fully state-contingent plan for the

households choice variableshow much to work, consume,

and save in the form of bondslooking forward from the

planning date t 0 and into the foreseeable future. At any point

in time, the household is obviously uncertain about the way

in which this future will unfold. However, we assume that the

household is aware of the kind of random external events, or

shocks, that might affect its decisions and, crucially, that it

knows the probability with which these shocks might occur.

Therefore, the household can form expectations about future

outcomes, which are one of the inputs in its current choices.

We assume that these expectations are rational, meaning that

they are based on the same knowledge of the economy and of

the shocks that buffet it as that of the economist constructing

the model. We use the notation Et X t + s to denote

expectations formed at time t of any future variable X t + s ,

as in equations 3.1, for example. The optimal plan, then,

is a series of instructions on how to behave in response to the

realization of each shock, given expectations about the future,

rather than a one-time decision on exactly how much to

work, consume, and save on each future date.

Together, the optimality conditions in equations 3.1

establish the negative relationship between the interest rate and

desired consumption that defines the demand side of the

model. The nature of this relationship is more transparent in

the special case of no habit in consumption ( = 0 ), when we

27

(3.3)

Rt

bt + 1 1

1

- .

- ----------- ----------------------- = E t ------------bt C t + 1 Pt + 1 Pt

Ct

consumption decreases when the (gross) real interest rate

Rt

------------------- increases, when expected future consumption

Pt + 1 Pt

decreases, and when households become more patient

( bt + 1 rises).

A log-linear approximation of the Euler equation (3.3),

after some manipulation, gives

(3.4)

yt = Et yt + 1 i t Et t + 1 t ,

is the continuously compounded nominal interest rate,

t Et log bt + 1 bt is a transformation of the demand shock,

and y t log Yt is the logarithm of total output. In this

expression, we can substitute consumption of the final good Ct

with its output Yt because in our model consumption is the

only source of demand for the final good. Therefore, market

clearing implies Yt = Ct .

In this framework, equation 3.4 is similar to a traditional IS

equation, since it describes the relationship between aggregate

activity y t and the ex ante real interest rate i t Et t + 1 , which

must hold for the final-good market to clear. Unlike a

traditional IS relationship, though, this equation is dynamic

and forward looking, as it involves current and future expected

variables. In particular, it establishes a link between current

output and the entire future expected path of real interest rates,

as we see by solving the equation forward

(3.5)

yt = Et

it + s t + s + 1 t + s .

s=0

directly affect current economic conditions. In fact, this

equation shows that future interest rates are just as important

to determine todays output as the current level of the shortterm rate, as we describe in our discussion of the role of policy

expectations.

In our full model, the Euler equation is somewhat more

complicated than in equation 3.4 because of the consumption

habit ( 0), which is a source of richer, and more realistic,

output dynamics in response to changes in the interest rate.

Nevertheless, these more intricate dynamics do not change the

qualitative nature of the relationship between real rates and

demand.

The third first-order condition of the household

optimization problem, equation 3.2, represents the labor

supply decision. It says that Americans are willing to work

more hours in firms that pay a higher wage and at times when

28

enough to have no significant effect on their income.6 Large

wage changes, in fact, would trigger an income effect and

lead the now richer workers to curtail their labor supply.

Mathematically, workers with higher income could afford

more consumption, which would lead to a drop in the marginal

utility t and thus to a decrease in labor supply at any given

wage level.

We can think of the labor supply schedule (equation 3.2)

as a relationship determining the wage that firms must pay

to induce Americans to work a certain number of hours.

In prosperous times, when demand is high and firms are

producing much, firms require their labor force to work long

hours and they must correspondingly pay higher hourly wages.

This is an important consideration in the production and

pricing decisions of firms, as we discuss in the next section.

The supply block of a DSGE model describes how firms set

their prices as a function of the level of demand they face. Recall

that in prosperous times, demand is high and firms must pay

their workers higher wages. As a result, their costs increase as

do their prices. In the aggregate, this generates a positive

relationship between inflation and real activity.

In terms of microfoundations, establishing this relationship

requires some work, since firms must have some monopoly

power to set prices. This is why our production structure

includes a set of monopolistic i-firms, which set prices, as well

as an f-firm, which simply aggregates the output of the i-firm

into the final consumption good. Because all the pricing action

occurs within the i-firms, we focus on their problem and omit

that of the f-firm.

Intermediate firm i hires Ht i units of labor of type i on

a competitive market to produce Yt i units of intermediate

good i with the technology

(3.6)

Yt i = At Ht i ,

process. We assume that At follows an exogenous stochastic

process, whose random fluctuations over time capture the

unexpected changes in productivity often experienced by

modern economiesfor example, the productivity boom in

the mid-1990s that followed the mass adoption of information

technology. We call this process an aggregate productivity shock,

since it is common to all firms.

Labor supply is upward sloping because is an increasing function, as is

convex. In other words, people dislike working an extra hour more intensely

when they are already working a lot rather than when they are working little.

competitive, as in Dixit and Stiglitz (1977), so firms set prices

subject to the requirement that they satisfy the demand for

their good. This demand comes from the f-firm and takes

the form

Pt i t

(3.7)

,

Yt i = Yt ----------Pt

where Pt i is the price of good i and t is the elasticity of

demand. When the relative price of good i increases, its

demand falls relative to aggregate demand by an amount

that depends on t .

Moreover, we assume that firms change their prices only

infrequently. The fact that firms do not adjust prices

continuously, but leave them unchanged in some cases for long

periods of time, should be familiar from everyday experience

and is well established in the economic literature (for example,

Bils and Klenow [2004]; Nakamura and Steinsson [2008]). To

model this fact, we follow Calvo (1983) and assume that in

every period only a fraction 1 of firms is free to reset its

price while the remaining fraction maintains its old price.7

The subset of firms that are able to set an optimal price at t ,

call it t 0 1 , maximize the discounted stream of expected

future profits, taking into account that s periods from now

s

there is a probability that they will be forced to retain the

price chosen today. The objective function of each of these

firms is therefore

s

s t + s

---------------- Pt i Yt + s i Wt + s i Ht + s i

Max E t

t

P

Pt i

s=0

additional constraint that they must satisfy the demand for

their product at every point in time

Pt i t + s

(3.8)

,

Yt + s i = Yt + s ---------- Pt + s

for s = 0 , 1, , . Profits, which are given by total revenue

at the price chosen today, Pt i Yt + s i minus total costs

s

Wt + s i Ht + s i , are discounted by the multiplier t + s t ,

sometimes called a stochastic discount factor, which translates

dollar profits in the future into a current dollar value.

The first-order condition of this optimization problem is

t + s 1

Wt + s i

s

- = 0,

t + s Yt + s Pt + s

Pt i t + s -----------------(3.9) E t

At + s

s=0

firm i , Wt + s i At + s is the firms nominal marginal cost at time

t + s 1

t + s , and t + s = ---------------- is its desired mark-upthe mark-up

t + s

In our estimated model in Section 5, we actually assume that the fraction

of firms that cannot choose their price freely can in fact adjust it in part to catch

up with recent inflation. This assumption improves the models ability to fit the

data on inflation, but it would complicate our presentation of the models

microfoundations without altering its basic message.

optimizing firms set their price as a mark-up over their

marginal cost. However, this relationship holds in expected

present discounted value, rather than every period, since a

s

price chosen at time t will still be in effect with probability

in period t + s.

We can rewrite the marginal cost of a firm that at time t + s

is still forced to retain the price Pt i as

(3.10)

Wt + s i H t + s i 1

S t + s i ------------------ = ----------------------------- ---------- t + s bt + s At + s

At + s

P i t + s

Y

A t + s Pt + s

= --------------------------------------------------,

A t + s t + s bt + s

t + s t

- -----------

---------

where we use the labor supply relation 3.2 to substitute for the

wage as well as the production function 3.6 and the demand

function 3.8 to give us an expression for the labor demand

Ht + s i .8 Inserting this expression into the first-order

condition 3.9, we see that the solution to the optimal pricing

problem is the same for all firms in the set t , since it depends

We denote this common optimal price as Pt .

t + s 1

The equation for the desired mark-up t + s = ---------------- , also

t + s

known as Lerners formulasays that monopolists facing a

more rigid demand optimally charge a higher mark-up, and

thus higher prices, since their clients are less sensitive to

changes in the latter. We assume that this sensitivitythe

elasticity of demandand thus the desired mark-up, follows

an exogenous stochastic process. Positive realizations of this

desired mark-up shock, which correspond to a fall in the

elasticity of demand, represent an increase in firms market

power, to which they respond by increasing their price.

Equation 3.9, together with the definition of the aggregate

price level as a function of newly set prices Pt and of the past

price index Pt 1

1

Pt 1 Pt

1 t

------------1 t 1 t

+ Pt

relationship between current inflation, future expected

inflation, and real marginal costof the form

(3.11)

t = st + Et t + 1 + ut ,

and st log St Pt is the logarithm of the real marginal cost.9

The sensitivity of inflation to changes in the marginal cost, ,

depends on the frequency of price adjustment , as well as on

market.

9

Variables are in logarithms, because equation 3.11, like equation 3.4, is

obtained by a log-linear approximation.

29

1 1 ,

other structural parameters, according to ------------------------------------- 1 +

H

where ----------- is the elasticity of the marginal disutility of

This Phillips curve, together with the expression for

marginal costs (3.10), provides the relationship between

inflation and real activity that defines the supply block of the

model. In fact, we see from equation 3.10 that marginal cost

depends on the level of aggregate activity, among other factors.

Higher economic activity leads to higher wages and marginal

costs. Thus, firms increase their prices, boosting aggregate

inflation.

Another important feature of the Phillips curve is that it is

forward looking, just as the Euler equation in the previous

section is. As in that case, therefore, we can iterate equation

3.11 forward to obtain

4Q

+ y yt yt +t ,

e

where rt , t, and yt are the baselines for the real interest rate,

4Q

inflation, and output, respectively, and t log Pt Pt 4 is

the rate of inflation over the previous four quarters. The

i

monetary policy shock t , a random variable with mean zero,

captures any deviation of the observed nominal interest rate

from the value suggested by the rule. This rule implies that,

if inflation and output rise above their baseline levels, the

nominal interest rate is lifted over time above its own baseline,

e

rt + t, by amounts dictated by the parameters and y and

at a speed that depends on the coefficient . The higher policy

rate, which is expected to persist even after output and inflation

have returned to normal, exerts a restraining force on the

t = E t st + s + u t + s ,

s

inflation is not stable, as policymakers

would like it to be, but fluctuates because

of the presence of mark-up shocks. This

is the essence of the monetary policy

trade-offs in the economy.

s=0

entire future expected path of marginal costs, and through

those, of real activity. But this path depends in turn on

expectations about interest rates, and thus on the entire future

course of monetary policy, as equation 3.5 shows. Hence,

we have the crucial role of policy expectations for the

determination of current economic outcomes in this model,

a feature we discuss in Section 2.

Monetary Policy

Recall that when the interest ratecurrent and expectedis

low, people demand more consumption goods (equation 3.5).

But if demand is high, firms marginal costs increase and so do

their prices. The end result is inflation. The opposite is true

when the interest rate is high. But where does the interest rate

come from? In DSGE models, as in the real world, the shortterm interest rate is set by monetary policy. In practice, this is a

decision made by a committee (the Federal Reserves Federal

Open Market Committee, or FOMC) using various inputs:

large data sets, projections from several models, and the

judgment of policymakers. Despite the apparent complexity of

the process, Taylor (1993) famously demonstrated that it can

be reasonably well approximated by assuming that the Federal

Reserve raises the federal funds rate when inflation and/or

output is high with respect to some baseline. This behavior is

assumed in almost all variants of DSGE models, although the

definition of the appropriate baselines is somewhat

controversial.

In our model, we assume that interest rates are set according

to the policy rule

30

i t = i t 1 + 1 r t + t + t t

(3.12)

e

this respect, t and yt can be regarded as targets of monetary

policythe levels of inflation and output that the central bank

considers consistent with its mandateand therefore do not

elicit either a restrictive or a stimulative policy.

In equation 3.12, we denote the central banks objective in

e

terms of production as yt , the efficient level of output. This

unobserved variable can be derived from the microfoundations

of the model.10 It represents the level of output that would

prevail in the economy if we could eliminate at once all

distortionsnamely, force the i-firms to behave competitively

rather than as monopolists and allow them to change their

prices freely. The level of activity that would result from such

a situation is ideal from the perspective of the representative

household in the model, as its name suggests. This is what

makes it a suitable target for monetary policy. However,

when output is at its efficient level, inflation is not stable, as

policymakers would like it to be, but fluctuates because of

the presence of mark-up shocks. This is the essence of the

monetary policy trade-offs in the economy. Achieving the

10

irrelevant for our purposes. We present in Section 4 an estimate of the behavior

of this variable over the last twenty years.

inflation. In contrast, a stable inflation implies deviations from

the efficient level of output. The two objectives cannot be

reconciled, but must be traded off of each other.

Related to the efficient level of output is the efficient real

e

interest rate, rt , which is the rate of return we would observe

in the efficient economy described above. This definition

implies that, when the actual real interest rate is at its efficient

level and is expected to remain there in the future, output will

e

also be at its efficient level. This is why we include rt in our

definition

of the baseline interest rate.

The other component of this baseline rate is the inflation

target t. We allow this target to vary slowly over time to

accommodate the fact that inflation hovered at about 4 percent

for a few years around 1990 before declining to nearly 2 percent

after the recession that ended in 1991. Nominal interest rates

were correspondingly higher in the first period, thus implying

a stable average for the real interest rate. We now present our

estimate of the evolution of the inflation target.

4. Empirical Approach

and Estimation Results

We estimate our model using data on the growth rate of real

GDP to measure output growth, yt , the growth rate of the

personal consumption expenditures chain price index

excluding food and energy (core PCE) to measure inflation, t ,

and the quarterly average of the monthly effective federal funds

rate to measure the nominal interest rate, i t . We measure

inflation by core PCE, rather than by a more comprehensive

measure, because the monetary policy debate in the United

States tends to focus on this index.

Our data span the period 1984:1 to 2007:4 (Chart 1). This is

the longest possible data set over which it is reasonable to argue

that U.S. monetary policy can be represented by a stable

interest rate rule. It follows the period of extremely high

interest rates in the early 1980s that brought inflation under

control. However, in the first few years of this sample, inflation

and the federal funds rate were still relatively high, with a fairly

abrupt reduction taking place around the 1991 recession. We

capture this low-frequency movement in inflation and the

nominal interest rate by including the slow-moving inflation

target t in the policy rule.

We use Bayesian methods to characterize the posterior

distribution of the parameters of the model. This distribution

combines the models likelihood function with prior

information on the parameters, using techniques surveyed, for

Chart 1

Observable Variables

Percent, annualized

12

Federal funds rate

10

8

6

4

2

0

Inflation

-2

GDP growth

-4

1984 86

88

90

92

94

96

98

00

02

04

06

of the Federal Reserve System.

methods is beyond the scope of this article. Instead, we focus on

the implications of these estimates for some key properties of

the model. Our objective is to show that the estimated model

provides a good fit to the data across many dimensions, but

also to highlight some of the models most notable

shortcomings.

We compare the second moments implied by the estimated

model with those measured in the data. Table 1 presents the

standard deviations of the observable variables, reported as

annualized percentages. In the model column, we report the

median and 5th and 95th percentiles of the standard deviations

across draws from the models posterior. This interval reflects

the uncertainty on the structural parametersand thus on

the model-implied momentsencoded in the parameters

posterior distribution. In the data column, we report the

median and 5th and 95th percentiles of the empirical standard

deviations in the data. This interval represents the uncertainty

on the true empirical moments because of the small sample

available for their estimation.

Our model does a very good job replicating the volatilities in

the data. It captures the standard deviation of output growth

and replicates quite closely the volatility of the nominal interest

rate, although it overestimates the standard deviation of

11

parameters.

31

Table 1

Percent

Variable

GDP growth

Core PCE inflation

Federal funds rate

Model

Data

2.03

[1.79, 2.37]

1.41

[0.98, 2.40]

2.23

[1.61, 3.56]

2.03

[1.74, 2.27]

1.15

[0.67, 1.38]

2.46

[1.55, 2.94]

Notes: The table reports the standard deviations of the observable

variables. The model-implied standard deviations are medians across

draws from the posterior; the 5th and 95th posterior percentiles across

those same draws are in brackets. The empirical standard deviations are

medians across bootstrap replications of a VAR(4) fit to the data; the

5th and 95th percentiles across those same replications are in brackets.

PCE is personal consumption expenditures.

volatility of the observable variables is not a preordained

conclusion, even if we freely estimate the standard deviations

of the shocks. The reason is that a likelihood-based estimator

tries to match the entire autocovariance function of the data,

and thus must strike a balance between matching standard

deviations and all the other second momentsnamely,

autocorrelations and cross-correlations.

These other moments are displayed in Chart 2. The black

line represents the model-implied correlation, with the shaded

area representing a 90 percent posterior interval. The solid blue

replicating the volatilities in the data.

It captures the standard deviation of

output growth and replicates quite closely

the volatility of the nominal interest rate,

although it overestimates the standard

deviation of inflation.

line is instead the correlation measured in the data, with a

90 percent bootstrap interval around this estimate represented

by the dashed lines. The serial correlation of output growth in

the model is very close to its empirical counterpart and well

within the data-uncertainty band. For inflation and the interest

rate, the model serial correlations are on the high end of the

32

component in both variables associated with the inflation

target, as we can infer from the variance decomposition

in Table 2.

According to the model, shocks to the inflation target

account for 85 percent of the unconditional variance of

inflation and 38 percent of that of the nominal interest rate.

Although we do not calculate a variance decomposition by

frequency, we know that the contribution of the inflation target

shock is concentrated at low frequencies, since this shock is

very persistent (the posterior mean of its autocorrelation

coefficient is 0.98). This finding suggests that the model faces

a trade-off between accommodating the downward drift in

inflation in the first part of our sample and providing a more

balanced account of the sources of inflation variability.

The rest of the variance decomposition accords well with

conventional wisdom. The productivity shock plays an

inflation target account for 85 percent of

the unconditional variance of inflation and

38 percent of that of the nominal interest

rate. This finding suggests that the model

faces a trade-off between accommodating

the downward drift in inflation in the first

part of our sample and providing a more

balanced account of the sources of

inflation variability.

important role in accounting for the volatility of output

growth, although the demand shock and the monetary policy

shocks (interest rate plus inflation target) are also nonnegligible. Moreover, the demand shock accounts for more

than half of the variance of the nominal interest rate. Finally,

mark-up shocks play a minor role as sources of volatility.

This finding has potentially important policy implications,

since in the model mark-up shocks are the only source of

the aforementioned policy trade-off between inflation and

real activity.

Returning now to the cross-correlations in Chart 2, we see

that the model is quite successful in capturing the lead-lag

relationships in the data. In our sample, there is no statistically

significant predictability of future inflation through current

output growth, a pattern that is reproduced by the model. The

Chart 2

Correlations

Corr. ( yt , t+k )

Corr. ( yt , yt-k )

1.0

0.4

0.8

0.3

0.2

0.6

0.1

0.4

0

0.2

-0.1

-0.2

-0.2

-0.3

-0.4

-0.4

Corr. ( t , t-k )

Corr. ( t , it+k )

1.0

0.8

0.8

0.6

0.6

0.4

0.4

0.2

0.2

-0.2

Corr. ( it , yt+k )

Corr. ( it , i t-k )

1.0

0.6

0.8

0.4

0.6

0.2

0.4

0

0.2

-0.2

0

-0.2

4

k

-0.4

-8 -7 -6 -5 -4 -3 -2 -1

0

k

Notes: The black line represents the median model-implied correlation across draws from the posterior; the shaded area represents the interval between

the 5th and 95th percentiles across those same draws. The solid blue line represents the median autocorrelation across bootstrap replications of a VAR(4)

fit to the data; the dashed blue lines represent the interval between the 5th and 95th percentiles across those same replications. Each statistic is calculated

at horizons k = 0, . . . 8 for autocorrelations and at horizons k = -8, . . . , 0, . . . 8 for cross-correlations.

inflation and the nominal interest rate present in the data both

in the leads and in the lags (the middle right panel of the chart).

The positive correlation between current interest rates and

future inflation might seem puzzling at first. We would expect

higher interest rates to bring inflation down over time, which

should make the correlation negative. However, over our

sample, this negative relationship is confounded by the lowfrequency positive comovement between inflation and the

nominal interest rate induced by the Fisher effect. Recall that

inflation and the nominal interest rate in fact are persistently

above their unconditional sample average over the first third

of the sample and are persistently below it after about 1992.

The bottom right panel of Chart 2 reports the dynamic

33

Table 2

Variance Decomposition

Percent

Shocks

Variable

GDP growth

Core PCE inflation

Federal funds rate

Demand

Productivity

Mark-Up

Interest Rate

Inflation Target

0.20

[.13, .28]

0.04

[.01, .06]

0.54

[.32, .76]

0.56

[.45, .67]

0.01

[.00, .02]

0.06

[.00, .13]

0.07

[.04, .10]

0.10

[.04, .17]

0.01

[.00, .02]

0.04

[.02, .06]

0.00

[.00, .01]

0.01

[.01, .02]

0.13

[.07, .19]

0.85

[.76, .94]

0.38

[.16, .61]

Notes: The table reports the share of the unconditional variance of each observable variable contributed by each shock. The point estimates are medians

across draws from the posterior; the 5th and 95th posterior percentiles across those same draws are in brackets. PCE is personal consumption expenditures.

rate. In the data, high growth rates of output predict high

nominal interest rates one to two years ahead, but this

predictability is much less pronounced in the model.

Moreover, this discrepancy is statistically significant in the

sense that the model-implied median autocorrelation lies

outside the 90 percent bootstrap interval computed from the

data. This failure to match the data highlights the main

empirical weakness of our model: its demand-side

specification. As in most of the DSGE literature, our demand

block consists of the Euler equation of a representative

consumer. Standard specifications of a Euler equation of the

type adopted here provide an inaccurate description of the

observed relationship between the growth rate of consumption

(or output, as in our case) and financial returns, including

interest rates, as first documented by Hansen and Singleton

(1982, 1983) and subsequently confirmed by many others (see

Campbell [2003] for a review). Improving the performance of

the current generation of DSGE models in this dimension

would be an important priority for future research.

We now report our estimates of a few of the variables that

play an important role in the model, but that are not directly

observable. We focus on the three latent variables that enter

the interest rate rule: the inflation target t, the output gap

e

e

yt yt , and the efficient real interest rate rt (Chart 3). As in

Charts 1 and 2, the black line is the median estimate across

draws from the models posterior and the shaded area

represents a 90 percent posterior probability interval.

Starting from the top panel, we note that the estimated

inflation target captures well the step-down in inflation from

a local mean above 4 percent between 1984 and 1991 to an

average value of around 2 percent since 1994. This permanent

reduction in inflation represents the last stage of the

34

Volcker in 1979, which became known as an example of

opportunistic disinflation (Orphanides and Wilcox 2002).

Needless to say, the estimated target is not completely smooth,

but it also displays some higher frequency variation. For

example, it reaches a minimum of around 1 percent at the

beginning of 2003, but moves closer to 2 percent over 2004.

(The next section studies in more detail the implications of

these movements.)

The middle and bottom panels of Chart 3 report estimates

of the output gapthe percentage deviation of output from its

efficient leveland of the efficient real interest rate. Several

features of the estimated output gap are noteworthy. First, its

two deepest negative troughs correspond to the two recessions

in our sample. In this respect, our model-based output gap

conforms well with more conventional measures of this

variable, such as the one produced by the Congressional

Budget Office (CBO). However, the shortfall of output from its

efficient level is never larger than 0.7 percent, even in these

recessionary episodes. By comparison, the CBO output gap is

as low as -3.2 percent in 1991. The amplitude of the business

cycle fluctuations in our estimated output gap is small because

the efficient level of output is a function of all the shocks in the

model and therefore it tracks actual output quite closely. The

last notable feature of the efficient output gap is that it displays

a very pronounced volatility at frequencies higher than the

business cycle. During the 1990s expansion, for example, it

crosses the zero line about a dozen times.

Compared with the output gap, the efficient real rate is

significantly smoother. Although some high-frequency

variation remains, the behavior of the efficient real rate is

dominated by swings at the business cycle frequency. The rate

spikes and then plunges for some time before the onset of

Chart 3

*t

7

6

questions, we examine a particular historical episode: the

puzzling pickup in inflation in the first half of 2004. This

exercise allows us to illustrate how we use the models forecasts

to construct alternative scenarios for counterfactual policy

analysis. Moreover, our analysis offers potentially interesting

lessons for the current situationalthough inflation has

recently been quite low, there has been some concern that

it might accelerate in the near future.

After approaching levels close to 1 percent between 2002

and 2003, core PCE inflation started moving higher in mid2003. This pickup accelerated significantly in the first half

5

4

3

2

1

0

-1

0.8

0.6

in Inflation in the First Half

of 2004

yt - yte

0.4

0.2

0

-0.2

address specific policy questions, we

examine a particular historical episode:

the puzzling pickup in inflation in the first

half of 2004. This exercise allows us to

illustrate how we use the models forecasts

to construct alternative scenarios for

counterfactual policy analysis.

-0.4

-0.6

-0.8

-1.0

e

rt

10

8

6

4

2

0

-2

-4

1984 86

88

90

92

94

96

98

00

02

04

06

Notes: The black line represents the Kalman smoother estimate of

the relevant latent variable conditional on the posterior mean of the

parameters; the shaded area represents the interval between the 5th

and 95th percentiles of the Kalman smoother estimates across draws

from the posterior. The vertical bands indicate NBER recessions.

interesting to note that the efficient real rate was negative for

the entire period between 2001 and 2004a time when the

FOMC was concerned about the possibility that the U.S.

economy would fall into a liquidity trap.12 A negative efficient

real interest rate is a necessary condition for the zero bound on

nominal interest rates to become binding, and hence for the

liquidity trap to become a problem.

12

reached their zero lower bound, as in Japan in the 1990s, and therefore cannot

be lowered any further.

about 1.5 percent to more than 2 percent, where it remained

until the end of 2008. We use our DSGE model to analyze

the sources of this unusually rapid and persistent step-up in

the level of inflation.

We organize our discussion around three questions. First,

was the surge in inflation forecastable? As we will see, the

answer to this question is no, at least from the perspective of

our model. Second, what accounts for the discrepancy between

the models forecast and the observed paths of inflation, output

growth, and the federal funds rate? Third, could monetary

policy have achieved a smooth transition to inflation rates

below 2 percent and, if so, at what cost in terms of added

volatility in output and the interest rate?

Chart 4 presents forecasts of quarterly core PCE inflation,

real GDP growth, and the federal funds rate from the DSGE

model. The forecast starts in 2003:1, when quarterly inflation

reached 1.1 percent (at an annual rate)its lowest level

following the 2001 recessionand extends through the

beginning of 2005. In each panel, the dashed line represents

35

inflation being as high as it was in that period.

From an economic perspective, it is interesting to note that

these sizable forecast errors for inflation roughly correspond to

the considerable period era that extended from June 2003 to

June 2004. At that time, the FOMC kept the federal funds rate

constant at 1 percent to guard against the risk of deflation,

while indicating in its statement that policy accommodation

can be maintained for a considerable period.13 According to

the models projection, this path for the federal funds rate

represents a deviation from the policy stance historically

maintained by the Federal Reserve in similar macroeconomic

circumstances. Based on the estimated interest rate rule, in fact,

Chart 4

3.5

2.5

1.5

0.5

-0.5

8

what would happen to the variables of

interest if we allowed the model economy

to run from its initial condition, without

introducing any innovations. Any observed

deviation from the forecast, therefore,

must be attributable to the realization of a

particular combination of such innovations.

4

2

0

-2

5

4

3

2

1

0

-1

2002

2003

2004

Notes: The dashed line represents the forecast of the relevant variable

conditional on the posterior mean of the parameters; the solid line

represents the observed realization. The shaded areas represent

50 (light blue), 75 (medium blue), and 90 percent (dark blue)

symmetric probability intervals for the forecast at each horizon.

PCE is personal consumption expenditure.

the expected value of the forecast, while the bands show the

50 (light blue), 75 (medium blue), and 90 (dark blue) percent

probability intervals. The solid line shows the realized data.

The model performs well in its forecast of output and the

federal funds rate, especially in the medium term. Inflation,

by comparison, is close to the mean forecast in 2003, but is

well above it in 2004 and beyond. Moreover, the probability

intervals for the forecast suggest that this realization of

inflation was quite unusual, as we see from the fact that the

solid line borders the 75 percent probability interval in the first

half of 2004. This means that in 2003:1, the model would have

36

the DSGE predicts a slow rise in the interest rate over 2003 and

2004. Instead, the FOMC maintained the federal funds rate at

1 percent through the first half of 2004.

However, the pickup in inflation over this period is

significantly more unusual than the deviation of the federal

funds rate from the historical norm. Actual inflation in 2004 is

mostly outside the 50 percent probability interval of the model

forecast (the light blue band), while the actual federal funds

rate remains well within it. Moreover, the acceleration in

inflation is not accompanied by unexpectedly high real growth,

suggesting that it cannot be fully explained by the traditional

channel of transmission from an overheated economy to

higher inflation.

What else, then, accounts for the unexpected and unlikely

deviation of inflation from the models forecast over 2004?

The DSGE framework provides a particularly useful way of

addressing this question. As we discuss in Section 2, the

economic outcomes predicted by the modelthe levels of

inflation, output, and the interest rateare the result of the

endogenous responses of the agents in the economy to the

13

This formulation was maintained in the FOMC statement from August 2003

to December 2003, and was later substituted with policy accommodation can

be removed at a pace that is likely to be measured.

Chart 5

Forecasts of Shocks

2

Demand

Productivity

0

-2

-1

-4

-2

-3

-6

1.0

2.0

Mark-Up

Inflation Target

1.5

0.5

1.0

0

0.5

-0.5

0

-0.5

-1.0

2002

2003

2004

2002

2003

2004

Notes: The dashed line represents the forecast of the relevant shock conditional on the posterior mean of the parameters while the solid line

represents an estimate of the realization based on the Kalman smoother. The shaded area represents the 75 percent symmetric probability

interval for the forecast at each horizon.

or desired mark-ups. The innovations to these driving

processes account for the deviations of the data from the

models forecast. In fact, the DSGE forecast is just a description

of what would happen to the variables of interest if we allowed

the model economy to run from its initial condition, without

introducing any innovations. Any observed deviation from the

forecast, therefore, must be attributable to the realization of a

particular combination of such innovations.14

Chart 5 depicts the combinations of exogenous driving

processes that, according to the estimated DSGE model, are

responsible for the observed path of inflation, output, and the

interest rate over the period we analyze. In each panel, the

dashed line represents the evolution of the shock associated

with the mean forecast while the solid line represents the

sequence of shocks corresponding to the actual realization of

the observable variables. As in Chart 4, the medium blue band

denotes the 75 percent probability interval for the forecast.

14

for shortand innovations. Driving processes can be autocorrelated, and thus

forecastable, while their innovations are i.i.d.

demand shock recovers from almost -4 percent to around

-1 percent. This movement is particularly pronounced during

2004, when inflation was picking up. However, this profile

is broadly consistent with the shocks expected evolution,

represented by the dashed line. The productivity shock is also

broadly in line with expectations, with the exception of 2003:3;

this spike in productivity accounts for the corresponding spike

in output growth in that quarter.

However, the most significant and direct contribution to the

surge in inflation comes from a sizable upward movement in

the inflation target, t. According to our estimates, this target

moves by about 1 percentage point, from less than 1 percent to

close to 2 percent. Moreover, this movement is at the edge of

the 75 percent probability interval for the forecast, suggesting

that the realization of this driving process is indeed quite

unusual.

To quantify more directly the effect on inflation of the

unexpected increase in the implicit inflation target, we depict

what would have happened to core PCE inflation in the

absence of such an increase (Chart 6). Here, the solid line

37

Chart 6

3

0

2002

2003

2004

Notes: The dashed line represents a forecast of inflation conditional on

the Kalman smoother estimates of all shocks except for those to the

inflation target; the solid line represents the observed realization.

The shaded areas represent 50 (light blue), 75 (medium blue), and

90 percent (dark blue) symmetric probability intervals for this

conditional forecast. Therefore, they represent uncertainty stemming

from future realizations of the inflation target shock alone. PCE is

personal consumption expenditure.

is realized inflation. The dashed line represents the counterfactual path of inflation predicted by the model in the absence

of shocks to the inflation target. In other words, this is a

forecast for inflation, conditional on the estimated path of all

but the inflation target shock. The bands therefore represent

the usual probability intervals, but in this case they are

computed around this conditional forecast.

The chart confirms our conclusion on the role of

innovations to the inflation target in accounting for the

observed evolution of inflation. According to the model, core

inflation would not have increased to above 2 percent, as it did

for most of 2004, without the steady increase in the inflation

target over the same period. In fact, inflation would have

remained within the comfort zone of 1 to 2 percent.

Moreover, note that the solid line of realized inflation is mostly

inside the area associated with the 90 percent probability

interval for the conditional forecast. This suggests that the

share of the forecast error in inflation accounted for by the

innovations in the inflation target in this episode is unusually

large compared with the historical average. This is just a more

formal way of saying that the increase in the inflation target is

disproportionately responsible for the observed increase in

inflation that we examine.

The estimated rise in the implicit inflation target provides

the missing link for a unified explanation of the pickup in

inflation, the considerable period monetary policy, and the

absence of a concomitant acceleration in output growth. In the

model, the inflation target is the main driver of movements

38

firms pricing behavior together with the amount of slack in

the economy. According to the DSGE model, therefore, a

significant fraction of the inflation acceleration in 2003-04 can

be attributed to a change in inflation expectations, driven by an

increase in the Federal Reserves implicit inflation target as

perceived by the private sector. This increase in the perceived

target in turn is consistent with the unusually loose stance

of monetary policy maintained by the FOMC during the

considerable period era.

This brings us to the third question: If the DSGE model

is correct, and the pickup in inflation in 2004 is attributable

to an increase in the implicit inflation target perceived by

the public, could the Federal Reserve have prevented this

development?

Charts 7 and 8 show the results of this counterfactual

analysis. Both charts display the data (solid line) along with the

counterfactual outcomes for the economy predicted by the

model under a policy consistent with the stabilization of core

inflation at 1.6 percent through 2004. The way in which this

a significant fraction of the inflation

acceleration in 2003-04 can be attributed

to a change in inflation expectations,

driven by an increase in the Federal

Reserves implicit inflation target as

perceived by the private sector.

policy is implemented, however, is different in the two cases. In

Chart 7, we present the outcomes associated with what we call

a no-communication monetary strategy (dashed line) while

in Chart 8 we compare these results with those that would

emerge under a full-communication strategy (blue line).

Under the no-communication strategy, the path for the

interest rate compatible with the desired evolution of inflation

is achieved each period through surprise departures from the

historical rule. In contrast, under the full-communication

strategy, the Federal Reserve implements the same path for

inflation by announcing an inflation target that is consistent

with it.15

15

that are compatible with the desired evolution of inflation, conditional on

the smoothed value of all other disturbances. Under the no-communication

i

strategy, the shocks we choose are the i.i.d. monetary shocks, t . Under

the full-communication strategy, our chosen shocks are to the inflation

target, t .

Chart 7

Chart 8

No-Communication Counterfactual

Full-Communication Counterfactual

3

12

12

10

10

-2

-2

-1

-1

-2

-2

2002

2003

2004

2002

2003

2004

economy predicted by our model had monetary policy been set to

achieve the path for inflation depicted in the top panel. This counterfactual is conditional on the posterior mean of the parameters. Under

the no-communication scenario, the desired path for inflation is

achieved by the choice of the interest rate shock while all other shocks

are set at their Kalman smoother estimate. The shaded area represents the

75 percent symmetric probability interval for the unconditional forecast,

which is the same as in Chart 4. The black line represents the observed

realization of each series. PCE is personal consumption expenditure.

economy predicted by our model had monetary policy been set to

achieve the path for inflation depicted in the top panel. This counterfactual is conditional on the posterior mean of the parameters. Under

the full-communication scenario, the desired path for inflation is

achieved by the choice of the inflation target while all other shocks are

set at their Kalman smoother estimate. The shaded area represents the

75 percent symmetric probability interval for the unconditional forecast,

which is the same as in Chart 4. The black line represents the observed

realization of each series. The dashed line is the conditional forecast

under the no-communication scenario. PCE is personal

consumption expenditure.

the two scenarios stems from the key role that expectations play

in the DSGE model. Under the full-communication strategy,

inflation expectations are immediately affected by the

announcement of an inflation target. These expectations in

turn have a direct effect on actual inflation without requiring a

contraction in real activity to force businesses to contain their

inflation expectations remain at their historical level. As a

result, inflation can be controlled only by increasing interest

rates to contain GDP growth.

The way in which we model the full-communication

scenario is quite stark. In practice, expectations would be

unlikely to adjust instantaneously, even if the Federal Reserve

39

were completely transparent about its inflation target. Nevertheless, the differences between the results of the two policy

strategies are striking. In the no-communication case, inflation

can be stabilized only through wild movements in the federal

funds rate. As a result, GDP growth is also extremely volatile:

it falls below zero in 2004:1, but then recovers to a quarterly

(annualized) growth rate of 10 percent and ends the period

likelihood of falling into such a trap.16 From this perspective,

our analysis might be interpreted as supportive of the policy

stance adopted by the central bank in 2003-04 as part of a

successful preemptive strike against a liquidity trap.

6. Conclusion

Our analysis might be interpreted as

supportive of the policy stance adopted

by the central bank in 2003-04 as part of

a successful preemptive strike against

a liquidity trap.

lie well outside the 75 percent forecast probability interval

reported in the chart. In fact, the quantitative details of the

evolution of output and the interest rate under the counterfactual simulations should not be taken literally, since they

depend significantly on the details of the model and on the

assumption that the central bank insists on perfectly stabilizing

current inflation. However, the qualitative pattern of higher

volatility under the no-communication strategy is a robust

feature of models in which expectations matter.

Under the full-communication strategy, in contrast, the

desired path for inflation can be achieved with much less

pronounced fluctuations in real growth and an almost

unchanged policy relative to the actual path. Interest rates need

not rise and output need not fall significantly because a shift in

expectations brought about by clear communication of the

Federal Reserves inflation objective largely brings inflation

under control.

Note that the results of these counterfactual exercises should

be interpreted with caution. Their objective is not to prescribe

an alternative to the policy followed in 2004, but rather to

investigate how a different path for inflation might have been

achieved. In fact, according to Krugman (1998) and Eggertsson

and Woodford (2003), an increase in inflation expectations

might be the best monetary strategy to escape a liquidity trap.

Many have argued that the main objective of the Federal

40

general equilibrium models and presents an example of their

use as tools for monetary policy analysis. Given the mainly

educational nature of our presentation, we simplify by using

a small-scale model designed to account for the behavior of

three key macroeconomic variables: GDP growth, core PCE

inflation, and the federal funds rate. Despite its simplicity, our

model is rich enough to reproduce some of the salient features

of the series of interest. It also allows us to highlight the

components common to more articulated and realistic DSGE

specifications.

Our model offers insight into the causes of the abrupt pickup in inflation in the first half of 2004, from levels close to

1 percent at the beginning of 2003 to values steadily above

2 percent through the end of 2008. This exercise highlights the

central role of expectations in the transmission of shocks and

policy impulses in DSGE models. The main lesson that we

derive from the exercise is that the most effective approach

to controlling inflation is through the management of

expectations, rather than through actual movements of the

policy instrument. This lesson seems to be well understood by

the public, given the amount of attention and speculation that

usually surround the pronouncements of central bankers on

their likely future actions. DSGE models have the potential

to broaden this understanding by adding a quantitative

assessment of the link between current policy, expectations,

and economic outcomesand thus to clarify the effect that

different systematic approaches to policy have on those

outcomes.

16

In its August 2003 statement, the FOMC observed that on balance, the risk

of inflation becoming undesirably low is likely to be the predominant concern

for the foreseeable future. Very low or negative levels of inflation are one of

the most likely triggers of a liquidity trap.

Technical Appendix

the parameters of the model. Further details on the parameters

and the structure of the model are available from the

corresponding authors.

Parameter

Distribution

Mean

Standard

Deviation

Calibrated

Gamma

Gamma

Beta

Beta

Beta

Normal

Normal

Normal

Normal

Normal

Beta

Beta

Beta

Beta

InvGamma

InvGamma

InvGamma

InvGamma

InvGamma

0.99

0.1

1.0

0.6

0.6

0.7

1.5

0.5

2.0

2.0

3.0

0.95

0.5

0.5

0.5

0.5

0.5

0.5

0.2

0.5

0.05

0.2

0.2

0.2

0.15

0.25

0.2

1.0

1.0

0.35

0.04

0.2

0.2

0.2

2.0

2.0

2.0

1.0

2.0

u

i

41

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The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York

or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the

accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information contained in

documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.

FRBNY Economic Policy Review / October 2010

43

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